By: Jared Sorin
In a rare example of bipartisan cooperation, Congress created a 100% exclusion from federal tax liability for gains on sales of qualified small business stock (“QSBS”), provided that the stock was acquired between September 23, 2010 and December 31, 2010. This long overdue display of positive government action, rather than gridlock, was partly motivated by the desperate need to stimulate the U.S. economy and create jobs. Politicians and pundits alike concluded that the federal tax exclusion would encourage job creation, innovation, revenue, profits, and wealth accumulation by motivating investors to invest in smaller companies, such as the technology-oriented startups that have become an increasingly critical part of the New York and national economies.
While securing the tax break is difficult – with procedural hurdles and a limited definition of QSBS – the tax break and its promise of increased return on investment for investors, nonetheless created a flurry of activity in the last quarter of 2010, as the tax break was short-lived, and scheduled to terminate at the end of 2010. Perhaps recognizing the economic value of the tax break, and hoping to earn political favor, Congress extended the 100% exclusion until the end of 2011. The results were clear and undeniably successful. Investment dollars flowed to QSBS, with substantial deal flow near the end of 2011, as the already extended tax break was scheduled to lapse on January 2, 2012.
On January 31, 2012, President Obama sent a Startup America Legislative Agenda to Congress that included a proposal to “expand and make permanent zero capital gains on small business investments,” which presumably is a reference to making the now-expired 100% gain exclusion on QSBS investments permanent. Moreover, his proposed budget includes the 100% exclusion.
Eliminating capital gains taxes on investments in startups should help these companies raise more money. In fact, The Kauffman Foundation, which specializes in entrepreneurship, estimates that an additional $7.5 billion over 10 years will be invested in startup companies if the tax break is made permanent. This recently released study is especially timely because pending legislation in Congress, backed by the President, would eliminate capital gains taxes entirely on investments in C corporations with less than $50 million in assets. The Kauffman Foundation estimate of how much additional investment this tax break would generate is based on how much money venture capitalists, angel investors, and entrepreneurs themselves currently invest in startups that are C corporations. In 2010, that number was around $10 billion. Exempting these investments from the capital gains tax rate should lead to a 7.5 percent increase in total investment in these startups, Kauffman estimates. Moreover, increasing investments in startups should create huge “dividends” for the US economy, especially with respect to job growth. Startups do, after all, “contribute the vast majority of net new jobs created in the U.S. economy.”